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Insights on the economy, markets, Dodd-Frank and prospects for recession from the Schwab brain trust

Schwab chief investment strategist Liz Ann Sonders. (Photo: AP)

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In a post-election conference call on Thursday, two members of Charles Schwab & Co.’s braintrust shared their insights, suggestions and projections for the markets, the economy, taxes, legislation and regulation—including implementation of Dodd-Frank in the 113th Congress that was elected on Tuesday.

The conversation confirmed that the biggest issue with the election now decided is the fiscal cliff: how Congress and the Obama administration deal with that package of tax, debt and sequestration issues will have a major impact on where the markets and the economy go, and how American investors feel about their own prospects.

To begin, Schwab chief investment strategist Liz Ann Sonders (left) suggested that the election yielded a status quo in the Washington political power equation, which “provides no clarity on the fiscal cliff.” Dealing with the cliff needs to be done, she said, “before we can open the valve to pent-up demand” and grow the economy. There is a chance for a recession in 2013, Sonders suggested, whose “magnitude” will be based on how we deal with the fiscal cliff. “Recessions tend to come when there have been big excesses” in an economy, but since, she said, “you can’t fall out of a basement,” any such recession would not be severe.

She mentioned that “some pundits think falling off the cliff could be positive,” since it would force government to deal with its long-term secular issues. “It’s not my base case or hope,” she said in referring to going over the cliff, “but it’s one way to see a silver lining” should that worse-case scenario occur. Noting that even the term “cliff” suggests going over it would be “steep and immediate,” in fact the effects “would be spread out,” especially on sequestration and more specifically on defense cutbacks.

While she warned that it’s “generally difficult in dealing with politicians to have specific” predictions of how they will behave, she expects any cliff-avoiding move will be “very 11th hour in nature” and whether or not Congress and thep president merely give the issue “a kick ahead or go over the cliff,” a deal will likely include “fundamental tax reform coupled with regulatory reform and entitlement reform,” an outcome she said “would be incredibly positive.”

When asked what could boost U.S. consumers’ confidence, she first suggested that confidence is in fact fairly high, helped by the recovery in the housing market. “It’s too soon to tell whether the election will boost confidence,” she said, but “if we see our politicians can get into the sandbox and play nicely,: there is cause for hope. She warned that “we’re not finished with difficult times for the stock market…in the near term there’s not much of a catalyst” for stock growth, and that “we may have more pain.”

Returning to the fiscal cliff scenario, the markets, she said, “don’t want piecemeal” attempts at reform, but rather to “tackle this in a secular, fundamental way,” that would improve American’s confidence in Congress; and would deliver “ultimate benefits to the economy that would be tremendous.”

That could come from the “coiled spring” she still sees poised in the economy, signified by the “hoarding of cash by companies not seen since World War II” and by rebuilding efforts after Hurricane Sandy, and that recent “positive offsets, not least being housing and, energy, and the trade numbers released today” could yield an increase in third quarter growth of GDP to “closer to 3%”

The sectors that could face pressure under a second Obama presidency? “The obvious ones are defense and financials,” due to Dodd-Frank and sequestration, but she said investors should be “careful about applying that long term.”

Election Results, Dodd-Frank and Regulation

Mike Townsend (right), VP of legislative and regulatory affairs for Schwab, addressed the election results and what they will mean for investors and advisors. In Washington, expect to see the “same polarized dynamic that has tied Washington in knots,” He expressed surprise at the number of Senate seats picked up by Democrats on Nov. 6—“a year ago, I would have thought that to be implausible”—and that while Speaker of the House John Boehner “struck a more conciliatory tone” in his post-election comments on the fiscal cliff, Townsend saw “no change in strategy” from the Republican leadership.

He expects the Congress nevertheless to focus on two big fiscal issues in the “next few weeks…fixing the AMT and postponing the auto cuts” under sequestration. “Some 25-30 million taxpayers will be paying higher rates for 2012” if the alternative minimum tax isn’t addressed this year, even if those taxpayers “won’t feel the hit until they file their taxes in 2013.”

He said there was “growing agreement” in Washington that the draconian sequestration spending cuts “will get postponed in some way because it would be too harsh in the current economy,” especially on defense spending, and he expects that there will be “some framework, a deadline, a process for tax reform” that won’t be decided upon until mid-December. One other trend he’s noticed in Washington: “Extending the payroll tax cut may be back in play—there are a number of Democrats talking about that over the last few weeks,” even if it isn’t a full extension.

One “clear outcome” from the election is that “Obamacare is here to stay,” meaning the new taxes on investment income of 3.8% will kick in in January.”

Another outcome: “Dodd-Frank overhaul is not going anywhere; there is a reluctance to open it up for revision” but suggested that instead there will be a focus on reducing the Dodd-Frank rule-writing backlog, especially on the Volcker rule, the regulation of derivatives and dealing with systemic risk.

When pressed for more insights into Dodd-Frank implementation, Townsend pointed out that “we’re gong to see a changeover in the House,” with Jeb Hensarling, R-Texas, taking over as chair from Spencer Bachus of Alabama, and with Maxine Waters, D-Calif., as the ranking Democrat on the Committee. On Sections 913 and 914, he suggested “there’s no consensus [in Congress], so things won’t change too much.” Post-election, “we’ll have a continued Democratic majority at the SEC and probably a new chair,” and that there may well be a “renewed effort” on regulating Fannie Mae and Freddie Mac. However, “Clearly, Dodd-Frank is here to stay.”